Refinancing Your ARM When It’s About To Reset

ARMs resetting to highest rate since 2009

At current mortgage rates, today's ARMs are resetting near 4%, which is the highest since 2009. Today's adjusting ARM rates also continue a 2-year streak during which refinancing an ARM garnered lower rates than refinancing one into a new ARM.

Prior to 2016, it's paid to have a conventional adjustable rate mortgage. Today, not so much.

If you've been riding your ARM through its adjustments, you've benefitted from low rates. With market sentiment shifting, though, it's time to consider a refinancing into something different—either a new ARM or a fixed-rate loan.

ARMs are expected to adjust higher through 2107 and into 2018 as well.

However, ARM interest rates fluctuate for the homeowners who use them, ARMs carry a financial risk not present with fixed-rate loans. For example, when you use an ARM to finance your home, there is no way to know what your mortgage rate will be in 10 years.

Uncertainty can be frightening. It can be hugely rewarding, too.

Consider this: since 2003, nearly every U.S homeowner using a conventional ARM home loan "beat the bank" on their mortgage. This is because, between 2003 and late-2015, adjustable-rate mortgages adjusted below the rates you could get on a "brand-new" loan (and with no closing costs required!).

That streak ended in December 2015, though, when the Federal Reserve raised the Fed Funds Rate from its target range near zero. When the Fed raises the Fed Funds Rate, it can affect the drivers for an adjusting ARM.

As a quick refresher, here's how adjustable-rate mortgages work.

For a fixed period of time, usually 5 or 7 years, your mortgage rate is constant

When the fixed period ends, your rate adjusts according to a preset formula

Once annually thereafter, your rate adjusts using the same preset formula

The preset formula is a simple one. The new rate for the adjustable-rate mortgage is the sum of some variable market rate -- typically the 12-month LIBOR -- and a predetermined constant, which is typically 2.25 percent.

Adding the constant and the variable shows your new rate. Today, that sum is (2.25) + (1.7), or 3.95%.

3.95% is a low mortgage rate, but it's higher than what you could get for a new 5-year ARM from an approved mortgage lender. According to Freddie Mac, new 5-year ARMs average 3.20 percent nationwide.

However, with a new ARM, there are closing costs to pay.

For example, in order to lock the 3.20% 5-year ARM rate shown by Freddie Mac, borrowers are expected to pay 0.5 discount points to the lender. And, closing costs apply, too.

If you prefer to let your loan adjust, you won't get access to the 3.20% rate -- but you won't be responsible for closing costs, either. This is because, with an adjusting loan, there are no appraisals, no verifications of your income, and no credit check required.

In addition, an adjusting loan requires no underwriting and no fees paid to title companies. You're not even required to have a job.

So, there are reasons to refinance away from your adjusting ARM, but allowing an adjustment can make sense to your cash flow, too.

If you allow your ARM to adjust (Option 1), your lender will assign a new mortgage rate based on today's LIBOR. Most homeowners will get a rate near 3.95% which will be assigned for the 12 months. The payment on a 3.95% mortgage rate is $475 for every $100,000 owed.

You can also refinance your ARM into new adjustable-rate loan.

Via a new ARM, you can lock your rate for the next 5 or 7 years or longer, depending on your needs. You'll postpone the adjustments of a recasting ARM and, according to Freddie Mac's most recent mortgage rate survey, will get an average rate of 3.20% for a 5-year ARM for an accompanying, one-time fee of 0.5 discount points.

The payment on a new ARM is $430 per $100,000, which saves $45 monthly but which is also subject to closing costs which could add up to the thousands, depending on in which state you live.

Lastly, you have the option of switching your ARM into a fixed-rate loan.

This is the most common way homeowners remove the uncertainty of "changing mortgage rates" and, according to quarterly refinance reports from the government, 66% of homeowners with ARMs make this choice.

Refinancing your ARM into a fixed-rate loan can be a good fit for several reasons -- especially if you expect that the economy will improve this year or next, and you plan to stay in your home for a few more years.

An improving economy moves LIBOR rates higher and LIBOR is the basis for your adjusted ARM mortgage rate. With a fixed-rate mortgage, you'll get a stable monthly because your interest rate is fixed and so is your payment.

If the answer to the last question is a resounding "no," get yourself to a lender and get yourself a fixed-rate refinance.

End of story.

However, if you expect to have your home and your mortgage for just a few years more, you may save a ton, again, with a new 3/1, 5/1, 7/1 or 10/1 ARM.

Your first step is determining what would happen to your ARM if it were adjusting today, and what it's likely to do in the near future.

To do this, you need to look at your loan paperwork and find your loan's index, margin and caps.

Suppose you have an ARM with a two-percent-per-year cap, a 2.25 percent margin and a five percent lifetime cap. Today's LIBOR index is near 1.70 percent, so if your loan were resetting today, your new rate would be 3.95 percent. If your current rate is 3.0 percent, your increase is only 0.95 percent, and that new rate is good for another year.

But what about subsequent years? Here are a few more figures for you.

The median value of the 1-Year LIBOR over the last 20 years is 1.90 percent. If your loan were resetting based on that value, your new rate would be 4.15 percent.

The highest rate your loan could hit at its next adjustment is 5.95 percent, because your per-year adjustment cap is two percent.

The highest rate your loan could reach in its lifetime is 8.0 percent, because its lifetime cap is five percent.

The Federal Reserve believes that by the end of 2017, the average 30-year fixed-rate mortgage will rise to 4.6 percent, and 15-year fixed mortgage rates will hit 3.8 percent.

Right now, ARMs just don't look that scary.

An in-depth explanation of ARM caps

Dig out your loan agreement, and there's a very good chance you'll discover up to three sorts of caps that limit the amount your rate (and therefore your payments) can rise.

These caps vary from mortgage to mortgage, so you need to do a bit of reading to find the protections yours provides.

Periodic adjustment caps

The first sort is intended to prevent sudden hikes that could be hard to absorb in your household budget. It sets a top limit (often two percent) on the amount by which your mortgage rate can rise each year.

You've probably seen these mortgages described as 3/1 ARMs, 5/1 ARMs, 7/1 ARMs and similar. The first number specifies the initial fixed-rate period in years, and the second shows (again in years) how often hikes are allowed after that. So a 5/1 ARM has five years fixed, and then permits rate increases every one year.

Payment caps

The second type of cap applies to your monthly payments rather than interest rates. It might, for example, say those monthly payments can't rise at any one time by more than a certain amount.

Suppose that particular cap is set at 7.5 percent in your loan agreement, and you're currently paying $1,000 a month. At most, you'd pay an extra $75 a month when your next hike is implemented.

Lifetime caps

The third sort of cap limits the amount by which your interest rate can rise in total over the lifetime of your loan.

These three types of cap together mean that even if interest rates suddenly soar, your exposure doesn't. That doesn't mean you won't face some pain, but it's probably less scary than you think.

How long will you keep your home and loan?

The first question may be the most important. If your current home is your "forever home," a fixed-rate mortgage might be your best bet, because it gives you the certainty and security of knowing your first monthly payment will be the same as your last: You know, the one when you become mortgage-free.

But if you're likely to move or refinance again anyway sometime in the next few years, it may not be worth paying the higher rates that typically come with fixed rates.

So how likely is it you'll move again to a new job? Perhaps to somewhere bigger to accommodate more kids or aging parents? Or to a downsized home? Maybe to a smarter neighborhood? Or, heaven forbid, to a post-divorce home?

Few people can answer those questions with total certainty. But your best guess could save you paying too high a rate for either an FRM or a longer-than-necessary fixed-rate period on your new ARM.

Adjustable-rate mortgages can be "safe"

An adjustable-rate mortgage is a mortgage for which the interest rate can change over time. Commonly abbreviated as "ARM", the adjustable rate mortgage is the opposite of the fixed-rate mortgage.

Adjustable-rate mortgages are available for most common loan types. You can use ARMs for conventional financing via Fannie Mae and Freddie Mac; and with FHA loans and VA loans, too.

The rules for how an adjustable-rate mortgage include two very important points. First, because the mortgage rate of an ARM doesn't change during its initial "teaser" period, during these first few years, an ARM behaves identically to a fixed-rate mortgage.

Second, when an ARM enters its adjustment phase, there are rules which govern by how much it can adjust in any given year. 5-year ARMs, for example, are capped to adjustments of ±2% per year, with the rate never allowed to move more than six percent from its starting rate.

As an illustration, with a 5-year ARM, the ARM mortgage rate remains unchanged for the first 60 months, and then it can adjust. The new mortgage rate after 60 months is equal to the then-current 1-Year LIBOR rate, plus 225 basis points (2.25%).

With LIBOR currently near 1.73, today's ARMs are adjusting to near 3.98 percent.

Keep in mind, though, that there are limits to how much the rate can rise.

A loan with an initial rate of 3.25% can never rise more than 9.25% if it has a 6% lifetime cap (3.25% + 6% = 9.25%).

Rates for an ARM can never reach 20%, nor can they fall to zero. They can only move within six percentage points of the original starting rate. There is safety in today's ARMs -- you always know the maximum by which your rate can change on its adjustment dates.

What are today's mortgage rates?

For U.S. homeowners with adjusting adjustable-rate mortgages, the best "refinance move" may be to skip the refinance entirely. You'll have to compare mortgage rates and see what's best for you.

Get today's live mortgage rates now. Your social security number is not required to get started, and all quotes come with access to your live mortgage credit scores.

Dan Green is an expert on topics of money. He has been featured in The Washington Post, MarketWatch, Bloomberg, and others.

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